Spot–future parity - Wikipedia
spot price according to fundamental market expectations. relationship between electricity spot and futures prices reflects expectations about future supply and. Afternoon Mock: Futures price is equal to the expected spot price minus a risk premium Page 37 Blue Box: Forward rates are upwardly. Spot–future parity (or spot-futures parity) is a parity condition whereby, if an asset can be purchased today and held until the exercise of a futures contract, the value of the future should equal the current spot price good for price S and conclude a contract to sell it one month later at a price of F, the price difference should.
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The contango hypothesis contends that the buyers of the products are the natural hedgers since they also want a guaranteed price, so they are willing to pay a higher price than the expected spot price to achieve that result. This results in higher future prices for longer-term contracts.FRM: Theory of normal backwardation
So contango exists in a futures market when future prices increase progressively with longer maturities. This is the most common situation, since many commodities, which are traded with futures contracts, have carrying costs, including storage, insurance, and financing plus there must be some compensation for the risk of holding the underlying asset.
If the short position does not hold the underlying, then a risk premium must be paid to compensate for the risk.
A contango market encourages investors to buy the near contracts and take delivery to sell in the later months, and for companies to increase stockpiles of the commodity. Obviously, whether backwardation or contango prevails depends on the preponderance of the short or long positions. The net hedging hypothesis stipulates that an excess of shorts will cause a normal backwardation, whereas an excess of longs will result in contango.
The Capital Asset Pricing Model CAPM modifies the above by quantifying the risk premium that is required to compensate the longs for the risk that they incur by entering a futures contract. So if a commodity poses a higher systematic risk, where its beta is greater than 1, then the future price must be lower than the expected spot price to compensate the long position for the greater risk.
Consider a stock and a hypothetical futures contract on that stock.
[L2] Relationship between futures price and expected spot price : CFA
The equation below relates the price of the stock to the initial price of its futures contract — which, according to the expectations hypothesis, will be equal to the expected price of the stock at time t — and the risk-free interest rate: Otherwise the farmer cannot induce the speculator to accept the long side of the contract.
From this point of view, the farmer in effect buys insurance from the speculator.
The farmer transfers his unwanted risk to the speculator and pays an expected profit to the speculator for bearing the risk. The payment to the speculator is the difference between the futures price and the expected future spot price.
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There is one situation in which the risk premium could disappear or even turn negative. Suppose the farmer can find other parties who need to purchase wheat and who would like to hedge by going long.
In that case it's possible for the two parties to consummate a futures transaction with the futures price equal to the expected spot price.
In fact, if the parties going long exerted greater pressure than the parties going short, it might even be possible for the futures price to exceed the expected spot price. When futures prices are lower than expected spot prices, the situation is called normal backwardation.
This should not be confused with a market that is in backwardation which means that the futures price is lower than the spot price. When futures prices are higher than expected spot prices, the situation is called normal contango.
This market is in A.